is a debt security, in which the authorized
issuer owes the holders a debt and is obliged to repay the
principal and interest (the coupon) at a later date, termed
stipulations may also be attached to the bond issue, such
as the obligation for the issuer to provide certain information
to the bond holder, or limitations on the behavior of the
are generally issued for a fixed term longer than ten years.
U.S. Treasury securities issue debt with life of ten years
or more, which is a bond. New debt between one year and
ten years is a "note", and new debt less than a year is
A bond is
simply a loan, but in the form of a security, although terminology
used is rather different. The
is equivalent to the
. Bonds enable the
issuer to finance long-term investments with external funds. Note
that certificates of deposit (CDs) or commercial paper are considered
to be money market instruments and not bonds.
In some nations,
are used irrespective
of the maturity. Market participants normally use the terms
for large issues offered to a wide public and
smaller issues originally sold to a limited number of investors.
There are no clear demarcations. There are also "bills" which
usually denote fixed income securities with terms of three years
or less, from the issue date, to maturity. Bonds have the highest
risk, notes are the second highest risk, and bills have the least
risk. This is due to a statistical measure called duration, where
lower durations mean less risk and are associated with shorter
stocks are both securities, but the major difference between the
two is that stock-holders are the owners of the company (i.e.,
they have an equity stake), whereas bond-holders are lenders to
the issuing company. Another difference is that bonds usually
have a defined term, or maturity, after which the bond is redeemed,
whereas stocks may be outstanding indefinitely. An exception is
a consol bond, which is a perpetuity (i.e., bond with no maturity).
of issuers of bonds is very large. Almost any organization could
issue bonds, but the underwriting and legal costs can be prohibitive.
Regulations to issue bonds are very strict. Issuers are often
classified as follows:
agencies, such as the European Investment Bank or the Asian
Development Bank issue supranational bonds.
Governments issue government bonds in their own currency. They
also issue sovereign bonds in foreign currencies.
provincial, state or local authorities (municipalities). In
the U.S. state and local government bonds are known as municipal
sponsored entities. In the U.S., examples include the Federal
Home Loan Mortgage Corporation (Freddie Mac), the Federal National
Mortgage Association (Fannie Mae), and the Federal Home Loan
Banks. The bonds of these entities are known as agency bonds,
(corporates) issue corporate bonds.
purpose vehicles are companies set up for the sole purpose of
containing assets against which bonds are issued, often called
issued by public authorities, credit institutions, companies and
supranational institutions in the primary markets. The most common
process of issuing bonds is through underwriting. In underwriting,
one or more securities firms or banks, forming a syndicate, buy
an entire issue of bonds from an issuer and re-sell them to investors.
Government bonds are typically auctioned.
The most important
features of a bond are:
principal or face amount the amount on which the issuer pays
interest, and which has to be repaid at the end.
date--the date on which the issuer has to repay the nominal
amount. As long as all payments have been made, the issuer has
no more obligations to the bond holders after the maturity date.
The length of time until the maturity date is often referred
to as the term or tenor or maturity of a bond. The maturity
can be any length of time, although debt securities with a term
of less than one year are generally designated money market
instruments rather than bonds. Most bonds have a term of up
to thirty years. Some bonds have been issued with maturities
of up to one hundred years, and some even do not mature at all.
In early 2005, a market developed in euros for bonds with a
maturity of fifty years. In the market for U.S. Treasury securities,
there are three groups of bond maturities:
term (bills): maturities up to one year;
term (notes): maturities between one and ten years;
term (bonds): maturities greater than ten years.
interest rate that the issuer pays to the bond holders. Usually
this rate is fixed throughout the life of the bond. It can also
vary with a money market index, such as LIBOR, or it can be
even more exotic. The name coupon originates from the fact that
in the past, physical bonds were issued which had coupons attached
to them. On coupon dates the bond holder would give the coupon
to a bank in exchange for the interest payment.
datesâthe dates on which the issuer pays the coupon to the
bond holders. In the U.S., most bonds are semi-annual, which
means that they pay a coupon every six months. In Europe, most
bonds are annual and pay only one coupon a year.
or covenants-- a document specifying the rights of bond holders.
In the U.S., federal and state securities and commercial laws
apply to the enforcement of those documents, which are construed
by courts as contracts. The terms may be changed only with great
difficulty while the bonds are outstanding, with amendments
to the governing document generally requiring approval by a
majority (or super-majority) vote of the bond holders.
a bond may contain an embedded option; that is, it grants option
like features to the buyer or issuer:
bonds give the issuer the right to repay the bond before
the maturity date on the call dates; see call option. These
bonds are referred to as callable bonds. Most callable bonds
allow the issuer to repay the bond at par. With some bonds,
the issuer has to pay a premium, the so called call premium.
This is mainly the case for high-yield bonds. These have
very strict covenants, restricting the issuer in its operations.
To be free from these covenants, the issuer can repay the
bonds early, but only at a high cost.
bonds give the bond holder the right to force the issuer
to repay the bond before the maturity date on the put dates;
dates and put dates the dates on which callable and puttable
bonds can be redeemed early. There are four main categories.
Bermudan callable has several call dates, usually coinciding
with coupon dates.
European callable has only one call date. This is a
special case of a Bermudan callable.
American callable can be called at any time until the
death put is an optional redemption feature on a debt
instrument allowing the beneficiary of the estate of
the deceased to put (sell) the bond (back to the issuer)
in the event of the beneficiary's death or legal incapacitation.
Also known as a "survivor's option".
fund provision of the corporate bond indenture requires a certain
portion of the issue to be retired periodically. The entire
bond issue can be liquidated by the maturity date. If that is
not the case, then the remainder is called balloon maturity.
Issuers may either pay to trustees, which in turn call randomly
selected bonds in the issue, or, alternatively, purchase bonds
in open market, then return them to trustees.
a bondholder exchange a bond to a number of shares of the issuer's
allows for exchange to shares of a corporation other than the
Fixed rate bonds
a coupon that remains constant throughout the life of the bond.
Floating rate notes
(FRN's) have a coupon that is linked to a money market index,
such as LIBOR or Euribor, for example three months USD LIBOR
+ 0.20%. The coupon is then reset periodically, normally every
High yield bonds
bonds that are rated below investment grade by the credit rating
agencies. As these bonds are relatively risky, investors expect
to earn a higher yield. These bonds are also called junk bonds.
Zero coupon bonds
not pay any interest. They trade at a substantial discount from
par value. The bond holder receives the full principal amount
as well as value that has accrued on the redemption date. An
example of zero coupon bonds are Series E savings bonds issued
by the U.S. government. Zero coupon bonds may be created from
fixed rate bonds by financial institutions by "stripping off"
the coupons. In other words, the coupons are separated from
the final principal payment of the bond and traded independently.
Inflation linked bonds
in which the principal amount is indexed to inflation. The interest
rate is lower than for fixed rate bonds with a comparable maturity.
However, as the principal amount grows, the payments increase
with inflation. The government of the United Kingdom was the
first to issue inflation linked Gilts in the 1980s. Treasury
Inflation-Protected Securities (TIPS) and I-bonds are examples
of inflation linked bonds issued by the U.S. government.
bonds, for example equity linked notes and bonds indexed on
a business indicator (income, added value) or on a country's
are bonds whose interest and principal payments are backed by
underlying cash flows from other assets. Examples of asset-backed
securities are mortgage-backed securities (MBS's), collateralized
mortgage obligations (CMOs) and collateralized debt obligations
are those that have a lower priority than other bonds of the
issuer in case of liquidation. In case of bankruptcy, there
is a hierarchy of creditors. First the liquidator is paid, then
government taxes, etc. The first bond holders in line to be
paid are those holding what is called senior bonds. After they
have been paid, the subordinated bond holders are paid. As a
result, the risk is higher. Therefore, subordinated bonds usually
have a lower credit rating than senior bonds. The main examples
of subordinated bonds can be found in bonds issued by banks,
and asset-backed securities. The latter are often issued in
tranches. The senior tranches get paid back first, the subordinated
also often called perpetuities. They have no maturity date.
The most famous of these are the UK Consols, which are also
known as Treasury Annuities or Undated Treasuries. Some of these
were issued back in 1888 and still trade today. Some ultra long-term
bonds (sometimes a bond can last centuries: West Shore Railroad
issued a bond which matures in 2361 (i.e. 24th century)) are
sometimes viewed as perpetuities from a financial point of view,
with the current value of principal near zero.
is an official
certificate issued without a named holder. In other words, the
person who has the paper certificate can claim the value of
the bond. Often they are registered by a number to prevent counterfeiting,
but may be traded like cash. Bearer bonds are very risky because
they can be lost or stolen. Especially after federal income
tax began in the United States, bearer bonds were seen as an
opportunity to conceal income or assets.
corporations stopped issuing bearer bonds in the 1960s, the
U.S. Treasury stopped in 1982, and state and local tax-exempt
bearer bonds were prohibited in 1983.
, often confused with Bearer bond, is a bond issued
in Russian roubles by a Russian entity in the Russian market.
bond is a bond whose ownership (and any subsequent purchaser)
is recorded by the issuer, or by a transfer agent. It is the
alternative to a Bearer bond. Interest payments, and the principal
upon maturity, are sent to the registered owner.
is a bond
issued by a state, U.S. Territory, city, local government, or
their agencies. Interest income received by holders of municipal
bonds is often exempt from the federal income tax and from the
income tax of the state in which they are issued, although municipal
bonds issued for certain purposes may not be tax exempt.
bond is a bond that does not have a paper certificate. As physically
processing paper bonds and interest coupons became more expensive,
issuers (and banks that used to collect coupon interest for
depositors) have tried to discourage their use. Some book-entry
bond issues do not offer the option of a paper certificate,
even to investors who prefer them.
is a bond
issued by a state, usually a European state. Interest is paid
like a traditional fixed rate bond, but the issuer will redeem
randomly selected individual bonds within the issue according
to a schedule. Some of these redemptions will be for a higher
value than the face value of the bond.
is a bond issued by a country to fund a war.
and valuing bonds
rate that the issuer of a bond must pay is influenced by a variety
of factors, such as current market interest rates, the length
of the term and the credit worthiness of the issuer.
are likely to change over time, so the market value of a bond
can vary after it is issued. Because of these differences in market
value, bonds are priced in terms of percentage of par value. Bonds
are not necessarily issued at par (100% of face value, corresponding
to a price of 100), but all bond prices converge to par when they
reach maturity. This is because if the prices do not converge,
arbitrageurs can make risk-free profit by buying the bonds at
a discount and collecting the face value at maturity. At other
times, prices can either rise (bond is priced at greater than
100), which is called trading at a premium, or fall (bond is priced
at less than 100), which is called trading at a discount. Most
government bonds are denominated in units of $1000, if in the
United States, or in units of 100, if in the United Kingdom. Hence,
a deep discount US bond, selling at a price of 75.26, indicates
a selling price of $752.60 per bond sold. (Often, bond prices
are quoted in points and thirty-seconds of a point, rather than
in decimal form.) Some short-term bonds, such as the U.S. Treasury
Bill, are always issued at a discount, and pay par amount at maturity
rather than paying coupons. This is called a discount bond.
price of a bond is the present value of all future interest and
principal payments of the bond discounted at the bond's yield,
or rate of return. The yield represents the current market interest
rate for bonds with similar characteristics. The yield and price
of a bond are inversely related so that when market interest rates
rise, bond prices generally fall and vice versa.
price of a bond may include the accrued interest since the last
coupon date. (Some bond markets include accrued interest in the
trading price and others add it on explicitly after trading.)
The price including accrued interest is known as the "flat" or
"dirty price". (
Accrual bond.) The price excluding
accrued interest is sometimes known as the Clean price.
rate adjusted for the current price of the bond is called the
current yield or earnings yield (this is the nominal yield multiplied
by the par value and divided by the price).
account the expected capital gain or loss (the difference between
the current price and the redemption value) gives the "redemption
yield": roughly the current yield plus the capital gain (negative
for loss) per year until redemption. The relationship between
yield and maturity for otherwise identical bonds is called a yield
unlike stock or share markets, often do not have a centralized
exchange or trading system. Rather, in most developed bond markets
such as the U.S., Japan and western Europe, bonds trade in decentralized,
dealer-based over-the-counter markets. In such a market, market
liquidity is provided by dealers and other market participants
committing risk capital to trading activity. In the bond market,
when an investor buys or sells a bond, the counterparty to the
trade is almost always a bank or securities firm acting as a dealer.
In some cases, when a dealer buys a bond from an investor, the
dealer carries the bond "in inventory." The dealer's position
is then subject to risks of price fluctuation. In other cases,
the dealer immediately resells the bond to another investor.
also differ from stock markets in that investors generally do
not pay brokerage commissions to dealers with whom they buy or
sell bonds. Rather, dealers earn revenue for trading with their
investor customers by means of the spread, or difference, between
the price at which the dealer buys a bond from one investor--the
"bid" price--and the price at which he or she sells the same bond
to another investor--the "ask" or "offer" price. The bid/offer
spread represents the total transaction cost associated with transferring
a bond from one investor to another.
bought and traded mostly by institutions like pension funds, insurance
companies and banks. Most individuals who want to own bonds do
so through bond funds. Still, in the U.S., nearly ten percent
of all bonds outstanding are held directly by households.
As a rule,
bond markets rise (while yields fall) when stock markets fall.
Thus bonds are generally viewed as safer investments than
, but this perception is only partially correct. Bonds
do suffer from less day-to-day volatility than stocks, and bonds'
interest payments are higher than dividend payments that the same
company would generally choose to pay to its stockholders. Bonds
are liquid it is fairly easy to sell one's bond investments, though
not nearly as easy as it is to sell stocks and the certainty of
a fixed interest payment twice per year is attractive. Bondholders
also enjoy a measure of legal protection: under the law of most
countries, if a company goes bankrupt, its bondholders will often
receive some money back (the recovery amount), whereas the company's
stock often ends up valueless. However, bonds can be risky:
bonds are subject to
interest rate risk
, meaning that
their market prices will decrease in value when the generally
prevailing interest rates rise. Since the payments are fixed,
a decrease in the market price of the bond means an increase
in its yield. When the market's interest rates rise, then the
market price for bonds will fall, reflecting investors' improved
ability to get a good interest rate for their money elsewhere
perhaps by purchasing a newly issued bond that already features
the newly higher interest rate. Note that this drop in the bond's
market price does not affect the interest payments to the bondholder
at all, so long-term investors need not worry about price swings
in their bonds and do not suffer from interest rate risk.
changes in a bond immediately affect mutual funds that hold these
bonds. Many institutional investors have to "mark to market" their
trading books at the end of every day. If the value of the bonds
held in a trading portfolio has fallen over the day, the "mark
to market" value of the portfolio may also have fallen. This can
be damaging for professional investors such as banks, insurance
companies, pension funds and asset managers. If there is any chance
a holder of individual bonds may need to sell his bonds and "cash
out" for some reason, interest rate risk could become a real problem.
(Conversely, bonds' market prices would increase if the prevailing
interest rate were to drop, as it did from 2001 through 2003.)
One way to quantify the interest rate risk on a bond is in terms
of its duration. Efforts to control this risk are called immunization
can become volatile if one of the credit rating agencies like
Standard & Poor's or Moody's upgrades or downgrades the
credit rating of the issuer. A downgrade can cause the market
price of the bond to fall. As with interest rate risk, this
risk does not affect the bond's interest payments, but puts
at risk the market price, which affects mutual funds holding
these bonds, and holders of individual bonds who may have to
bondholders may lose much or all their money if the company
goes bankrupt. Under the laws of many countries (including the
United States and Canada), bondholders are in line to receive
the proceeds of the sale of the assets of a liquidated company
ahead of some other creditors. Bank lenders, deposit holders
(in the case of a deposit taking institution such as a bank)
and trade creditors may take precedence.
There is no
guarantee of how much money will remain to repay bondholders.
As an example, after an accounting scandal and a Chapter 11 bankruptcy
at the giant telecommunications company Worldcom, in 2004 its
bondholders ended up being paid 35.7 cents on the dollar. In a
bankruptcy involving reorganization or recapitalization, as opposed
to liquidation, bondholders may end up having the value of their
bonds reduced, often through an exchange for a smaller number
of newly issued bonds.
are callable, meaning that even though the company has agreed
to make payments plus interest towards the debt for a certain
period of time, the company can choose to pay off the bond early.
This creates reinvestment risk, meaning the investor is forced
to find a new place for his money, and the investor might not
be able to find as good a deal, especially because this usually
happens when interest rates are falling.
A number of
bond indices exist for the purposes of managing portfolios and
measuring performance, similar to the S&P 500 or Russell Indexes
for stocks. The most common American benchmarks are the Lehman
Aggregate, Citigroup BIG and Merrill Lynch Domestic Master. Most
indices are parts of families of broader indices that can be used
to measure global bond portfolios, or may be further subdivided
by maturity and/or sector for managing specialized portfolios.
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